Nearly everybody needs a car. But not everybody has the means to purchase one with hard cash, as cars are expensive and pretty much long-term investments. For example, if you are planning to get a second car for your family of 7, your best option is to get a Honda Pilot; Provided you are not keen on minivans. However, Honda has dropped the base trim levels and the lineup starts with EX-L with a starting price tag of 40 grand.
40k USD upfront investment is huge and that could eat up nearly 1/3rd of your annual income which could be put to better use if invested properly. That’s why, financing a car is the most common way of procuring a car, not just in the United States, but all over the world. Car loan is something everyone should be aware of and this article aims to enlighten you on that subject.
What is car financing?
You can either purchase a new car or a used car depending on your budget. However, not everyone has the capital necessary to purchase a car right away, and saving up that amount of money can sometimes take years. Financing a car is a way better option and it reduces strain on the budget. You borrow money to buy the car and then pay it back over time with interest. You could also deposit a downpayment right at the beginning of the loan (this is what you call a partial loan) or you could borrow the entire amount (this is what you call a zero-deposit loan).
When you finance your car, you sign an agreement to pay a specific amount back to the lender each month for a mutually agreed-upon time limit (number of months). At the end of the time limit, the agreement is fulfilled – you have your car and the lender has their money. In the US, the average time limit for a loan is around 69 months and the average rate of interest is 4.09%.
How is the rate of interest calculated?
Calculating the rate of interest depends on various factors and it varies from person to person, location to location, and so on. The primary factors which determine the interest are the person’s credit score, credit history, capital required, loan duration, location, demographics, and various other factors. These factors are examined by the lender while they run a background check on you and then decide upon a rate.
However, the rate of interest also depends upon the lender. Some lenders might offer less interest as compared to others; you can try different lenders and compare the interest each of them provides before signing an agreement.
Ways of financing a car
- Car financing with a loan
- Loaning a car is the easiest way to procure a car without much hassle. As we explained, you borrow money from a lender, buy the car, and repay it over time in monthly installments. The most important factors of a car loan include down payment, loan amount, loan duration, and interest rate.
- Car financing with a lease
- Leasing is somewhat similar to a loan but it has a few key differences. Leasing is like a long-term rental. You don’t exactly own the car, ever. You rent it and have to return it at the end of the agreement period. The term of a lease is less than that of a loan, usually 24 to 36 months. Usually, leasing a car results in cheaper monthly payments than loaning a car, but you have to return the car at the end of the term.
- Direct lending
- Direct lending is one of the most common. You could arrange a loan from banks or from credit unions before you visit the dealership to buy the car. You can also try NBFCs. Depending on what they offer- loan amount, terms and interest rate, you could explore a few cars that fit the budget. This reduces disappointment from expectations about your new car purchase and also makes sure you don’t overspend.
- Dealership financing
- If you don’t want to go to a bank for a loan, you could head to the dealership and get a loan directly. Sometimes, the car manufacturers themselves offer special financing. However, these deals are only available through the dealer. For example, Ford Motor Credit and Toyota Financial Services are financing divisions of the said car companies and are ”captive lenders” since they are bound to a particular carmaker. Such lenders offer low-interest rates and also offer certain incentives on certain models. There are also options for 0% interest rates which can only be availed by people with excellent credit scores. You can also get a loan directly from the dealership for a used car as well.
How does your credit score come into play?
- Credit scores play a huge role when you go out to get a car loan. If your credit scores are bad, you might only be able to get a loan with a higher interest rate or you might not be able to get a loan at all. Your credit score reflects your finance habits – your income source, assets bought, repayment history and loan defaults among other things. No agency wants to take a chance with someone who might default on their loan. That is why having a high credit score is very important. Higher credit scores also unlock a broad range of incentives and offers.
Here is a breakdown of the credit score range –
- Super Prime: 781-850
- Prime: 661-780
- Non Prime: 601-660
- Subprime: 501-600
- Deep subprime: 300-500
The average credit score for a new car loan is around 732. So you must have a pretty good credit score to secure a decent car loan. But if you want to purchase a used car, a score of around 665 would be enough. Not a whole lot of people below the score of 601 can secure car loans. So, make sure to maintain a good credit score.